US politics: Powell selcted for Fed chair, tax cut details a challenge - Westpac

Analysts at Westpac noted the day's politics that moved markets in the US sesison.

Key Quotes:

• Powell new Fed Chair, same policies

As widely expected President Trump has nominated Jerome Powell to the role of Fed Chair, breaking with long standing tradition of nominating the Chair for a second term. Powell is expected to maintain a steady course when it comes to both further gradual interest rate hikes and balance sheet normalisation.

Unless economic conditions shift meaningfully Fed policy is on a very well established track encompassing continued gradual rate hikes and balance sheet normalisation - a policy path that Powell has repeatedly affirmed.

On both front's the Fed's communication has been crystal clear: the Fed plans to lift its benchmark rate in a measured fashion toward neutral over the next several years, the Fed's dots signaling a median projection of three hikes in 2018 and 2 1/2 hikes in 2019. Powell's dots are likely close to the median. Powell’s main challenge will be navigating monetary policy through a low wage and inflation environment as Fed Funds approaches short term estimates of neutral and as the reduction in the Fed’s balance sheet gathers pace. The latter has commenced under a very precise set of parameters - as of October the pace of Agency MBS and Treasury reinvestment is slowing by a combined total of $10bn per month, rising in increments of $10bn every three months until a maximum cap of $50bn per month is hit in a year's time. Fed officials have gone to great lengths to emphasise that balance sheet normalisation will be passive and predictable.

There are still three vacancies on the Board including the Vice Chair role, the likes of John Taylor thought to be still very much in the running. A Chair/Vice Chair combination with a disruptive hawkish outsider like Taylor would on balance have a more hawkish feel than Yellen and Fisher. The rotating schedule for 2018 among the regional Presidents also has a hawkish lean to it: doves like Kashkari and Evans are replaced by known hawk Mester and Mullinex, the latter representing the traditionally hawkish Richmond district.

• US tax cuts: new details, same challenges

House Republican legislators have released more details. The basic thrust of the plan is intact, namely, sweeping tax cuts for corporates, from 35% to 20%; full expensing of CAPEX but only for a five year period; cutting personal income taxes along with the number of brackets from seven to four (12%, 25%, 35% and 39.6% for high income earners); and a new 25% tax rate for so called “pass through businesses” (i.e. small business) who pay taxes based on the personal income brackets. The foreign earnings tax holiday is there too but the rate will be 12%, higher than the earlier mooted 8% and well above the 5% used in the 2005 tax holiday, implying potentially less repatriation flow into the US. Thereafter the plan envisages a 10% tax on foreign earnings but only for high income foreign subsidiaries.

A bunch of key deductions will be scaled back to fund these tax cuts: the corporate debt interest deduction, the mortgage interest deduction (only on new home sales) and the state and local income tax deduction. Material opposition to the repeal of these deductions is ramping up but supporters of the plan will note that there’s also a doubling of the standard deduction (a fixed amount of income that is exempt from taxation for all taxpayers), expanded temporary family tax credits and the alternative minimum tax will be removed (a supplementary tax designed to keep high income earners from using loopholes).

House Committees will be meeting from next week while the Senate will release its own tax bill next week too. The expectation is for the legislation to be passed through both chambers by year’s end but that is a challenging timeline - Congress meets for just 21 days before the year is out and a single reconciled bill needs to pass both houses.

Legislators cannot bank on a single Democrat vote and public and congressional opposition to many measures that will fund tax cuts will intensify in coming weeks. Capping the mortgage interest deduction on new loans at $500k, down from $1mn, has drawn the ire of the National Association of Realtors who have commenced an aggressive opposition campaign. The National Association of Small Business (NFIB) has also voiced opposition against the plan for a 25% tax rate for so called “pass through businesses”, noting it leaves for too many of their members behind.

In Congress the fate of the plan lies with House Republicans in high tax states (there are 30+ in the 10 states that have the highest taxes) and ½ dozen centrist Republicans in the Senate.

The budget resolution passed a couple weeks ago that created the foundation for fast track tax cuts that gets around a Democrat filibuster included 20 House Republican “no” votes, all from districts where local taxes are high and whose constituents benefit heavily from the state and local income tax deduction. With today’s plan showing a meager $10k maximum state and local property tax deduction that opposition is still there judging by early comments from Republicans in these districts. Yet, eliminating the state and local income tax deduction is necessary to stay within the $1.5trn “guard rail” - the 10 year legislated allowance for tax cuts.

The support of a handful of centrist Senate Republicans also hangs in the balance. The Tax Policy Center costed a nearly identical version of today’s plan at $2.4trn over a decade - more than the $1.5trn allowance - and that optimistically assumes various highly contentious revenue raisers will make it through. This plan can only fit inside the $1.5trn guard rail by assuming unrealistically high GDP growth. But that won’t be credible with many mainstream Senate Republicans, who will instead continue to be guided by the official scorekeeper, the Congressional Budget Office (CBO). They are unlikely to dramatically ramp up their long term growth estimates (currently 1.9% pa next 10 years).

Today’s tax package will undergo several re-writes and given the contentious debate on day one the final version is likely to be delayed and will be smaller in scope. The market reaction to today’s tax plan details has been equally lukewarm."